Information Reliability and Welfare: A Theory of Coarse Credit Ratings

Goel, Anand M.; Thakor, Anjan V.

doi:10.2139/ssrn.2440750

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Information Reliability and Welfare: A Theory of Coarse Credit Ratings

46 Pages Posted: 24 May 2014

See all articles by Anand M. Goel

Washington University in St. Louis - John M. Olin Business School; Financial Theory Group; European Corporate Governance Institute (ECGI); Massachusetts Institute of Technology (MIT) - Laboratory for Financial Engineering

Date Written: May 22, 2014

Abstract

An enduring puzzle is why credit rating agencies (CRAs) use a few categories to describe credit qualities lying in a continuum, even when ratings coarseness reduces welfare. We model a cheap-talk game in which a CRA assigns positive weights to the divergent goals of issuing firms and investors. The CRA wishes to inflate ratings, but prefers an unbiased rating to one whose in ation exceeds a threshold. Ratings coarseness arises in equilibrium to preclude excessive rating inflation. We show that competition among CRAs can increase ratings coarseness. We also examine the welfare implications of regulatory initiatives.

Keywords: credit ratings, coarseness, cheap talk, credit quality

JEL Classification: D82, D83, G24, G28, G31, G32

Suggested Citation: Suggested Citation

Goel, Anand M. and Thakor, Anjan V., Information Reliability and Welfare: A Theory of Coarse Credit Ratings (May 22, 2014). Available at SSRN: https://ssrn.com/abstract=2440750 or http://dx.doi.org/10.2139/ssrn.2440750